Don’t Fall for These Myths About ESG in Emerging Markets

Author:
John Bates
Head of EM Corporate Research
Emerging Markets Fixed Income

9 May 2019

The consideration of environmental, social, and governance (ESG) factors is an essential component of any rational investment strategy. Yet emerging markets (EM) often face a “perception shortfall” compared with developed markets (DM) when it comes to ESG factors. The truth is emerging markets are driving global economic growth, and ESG factors have never been more important to investors looking to harness this growth. Many investors, however, cling to some false notions concerning ESG in EM that keep them from realizing the sector’s potential. Here, we dispel five myths about ESG in EM.

Myth 1: ESG risks are higher in EM than in DM.

Reality: History shows us that the most momentous cases of ESG failure occur because of human shortfalls caused mostly by poor management decisions and, in many cases, desire to maximize profits. Of course, a colossal gap stretches between the strong and the weak credits in both EM and DM, but the best-run companies in EM are also among the best-run in the world. A high proportion of EM companies have global operations and are penalized for being based in countries with poor macroeconomic dynamics. Whether it’s Exxon Valdez or Chernobyl, Bernie Madoff, Telexfree or Enron or the Petrobras Lava Jato scandal, the biggest ESG-related crises occur in all regions – developed or emerging.

Demand for corporate responsibility and disclosure is a global requirement for investors in EM and DM in equal measure. The diversity of the investible market in EM demands an active, credit-intensive, and selective approach, which means investors have to engage with company management teams to assess the corporate culture and controlling influences. These are common factors in our ESG approach for both EM and DM.

Myth 2: ESG data in EM is lacking.

Reality: EM data related to ESG does exist, but it can be compiled and assessed only in conjunction with a thorough fundamental credit process. EM represents a vast and diverse investible universe incorporating over 70 countries, and its traded debt markets have a market capitalization of over $22 trillion. Yet EM represents only around 7% of global bond indexes, and its debt stock represents only 27% of the world’s total1. EM is therefore hugely underrepresented in investment terms, which goes some way to explaining the perception that ESG data is scarce.

Our investment process incorporates credit fundamentals as well as ESG parameters to screen for risks across our investible universe. After that screening, today we have nearly 400 companies across EM currently under active coverage, with each having a full suite of ESG data. This level of data-gathering is possible only with a dedicated analyst team that’s constantly kicking the tires and asking company management teams pointed questions. The quality of ESG data for these names is high: Over 90%2 of our active coverage companies produce financial accounts complying with International Financial Reporting Standards (IFRS) and have public stock market listings. Plus, over 95%2 have credit ratings from the three leading credit rating agencies. Of the EM dollar bond corporate universe under our coverage, 65%2 is rated investment grade.

Myth 3: Markets do not price in ESG factors in EM.

Reality: ESG factors are very much priced into valuations in EM. But the hugely diverse universe makes valuations extremely varied across industry sectors and regions, making valuations multifaceted.

The Data Set Is Diverse Among Quasi-Sovereign Spreads, Ratings, and ESG Scores

The Data Set Is Diverse Among Quasi-Sovereign Spreads, Ratings, and ESG Scores

Source: PineBridge Investments, Bloomberg, Standard & Poor’s, Moody’s, Fitch as of April 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.

For example, South Africa’s national power company, Eskom, has the lowest credit ratings, the highest spread versus its host country’s bonds, and the highest-risk ESG score, which all makes intuitive sense (since higher risk equals higher spreads). Russian gas producer Gazprom, on the other hand, has a higher credit rating, a comparatively high-risk ESG score, and yet the lowest spread versus its host country’s bonds. Several factors explain the anomaly, including the sovereign’s influence/support and credit rating, the macroeconomic dynamics of the country, and Gazprom’s stand-alone credit profile.3

Valuations are constantly affected by events that have an impact on a company’s creditworthiness as well as on its ESG profile. This was illustrated earlier this year when the failure of an iron ore tailings dam operated by Brazil’s Vale caused massive environmental damage and loss of life. The dislocation of Vale (rated Ba1/BBB-/BBB-) versus the Brazilian sovereign (rated NR/BB-/BB-) in January shows the market’s immediate negative reaction.4

Vale's Dislocation From the Sovereign Shows How EMs Value ESG

Vale's Dislocation From the Sovereign Shows How EMs Value ESG

Source: Bloomberg as of April 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.

Myth 4: ESG in EM does not help investment returns.

Reality: Strong evidence now suggests that the addition of an ESG framework does provide an extra layer of protection, especially in periods of market stress. ESG matters are often classed as nonfinancial, but they may have a material impact on the operations of debt issuers and, therefore, may affect risk and returns for investors. In June 2013, MSCI launched its MSCI Emerging Markets Leaders Index, which is a capitalization-weighted equities index providing exposure to EM companies with high ESG performance relative to their sector peers. Performance clearly shows that cumulative returns are higher when ESG considerations are taken into account. Also note that the ESG index is more concentrated (408 constituents) than the EM Index (1,136).4

ESG Can Have a Positive Impact on Investment Returns

ESG Can Have a Positive Impact on Investment Returns

Source: Bloomberg, MSCI as at April 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.

For fixed income, the evidence is less compelling on an index basis. JP Morgan launched its ESG corporate and sovereign bond indexes in April 2018. These indexes use “exclusions” from the standard corporate and sovereign indexes to get to their ESG equivalents. For example, the, JP Morgan’s ESG Corporate CEMBI (Corporate Emerging Market Bond Index) excludes about 23% of issuers in the standard CEMBI Broad Diversified Index. Issuers are excluded for having ESG scores that fall below a certain level, or for more specific reasons, such as being thermal coal producers or violating United Nations Global Compact (UNGC) principles. Taking out these higher-risk issuers creates an essentially “greener” index that’s less volatile, but generally the return profiles are similar: In the 12 months to April 2019, JP Morgan’s ESG Corporate Index returned just 14 bps less than its baseline CEMBI BD Index5. For a similar return profile, the greener index is clearly preferable.

Our analysts conduct their ESG risk analysis alongside their bottom-up fundamental credit analysis, following UNGC principles. This helps us screen out the biggest challenges in EM. For example, during 2018 we avoided Petroleos de Venezuela, which was the worst-performing corporate issuer in our universe.

Myth 5: Green bonds are key to ESG investment in EM.

Reality: Not yet. Green bond issuance hit record levels in fourth-quarter 2018 and first-quarter 2019, bringing the global green bond universe up to $430 billion (over 10x the level in 2013)6. But according to the Institute of International Finance, only 12% are tradeable internationally, and this is still only a tiny 0.4% of the global bond market6. China, France, and Germany are the major green bond issuers, but these are generally not openly traded. For EM, green bonds are, therefore, insignificant at this stage.

One of the key challenges for the development of the EM green bond market is that issuers face additional administrative/legal costs and expect investors to meet these costs in the form of cheaper pricing. However, investors have yet to be convinced that an issuer coming to the market with a green bond is justified in paying less interest than for a conventional bond.

“Greenwashing” is also a concern in EM. That’s when investors become skeptical over how the bond proceeds will be used in regions with poor governance.

All that said, the City of Cape Town, Argentina’s La Rioja Province, and National Bank of Abu Dhabi have all recently issued green bonds. The boom in Chinese green bond issuance is a clear sign that the authorities there are pushing for a cleaner environment, which has to be positive.

More than a footnote

Five years ago, ESG was essentially a footnote during our meetings with clients. Now, it typically forms a major segment on our meeting agendas. As more issuers recognize that ESG considerations in emerging markets are critical for long-term success, investors would be wise to shed the myths that may be holding them back from potential rewards.

Footnotes

1Global bond indexes represented by Bloomberg Barclays Global Aggregate Index. Source: IMF, Bloomberg, Barclays and PineBridge Investments as of 31 October 2018. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.
2Source: PineBridge Investments as of April 2019.
3Source: PineBridge Investments, Bloomberg, Standard & Poor’s, Moody’s, Fitch as of April 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.
4Source: Bloomberg, MSCI as of April 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.
5Source: JP Morgan as of April 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Indices are unmanaged. An investor cannot invest directly in an index.
6Source: The Institute of International Finance as of April 2019.

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